Mervyn King’s gilts move very welcome

IT was a brave decision – and one few thought the Bank of England would choose to make. Its decision not to increase its quantitative easing target from £125bn to £150bn, contrary to what was widely expected, must mean that it is confident the economy is starting to grow again or is at least stagnating; that it believes there are risks to inflation if it continues injecting liquidity into the economy; and that the government needs to find a more sustainable source of finance for its budget deficit.

It also means that gilts purchases will now decrease in intensity: the Bank has so far spent a total of £113bn buying assets of different kinds and it will have to reduce its purchases from £6.2bn a week to something closer to £2-3bn if it is to avoid hitting the £125bn before its next monetary policy committee meeting. It will buy £4.5bn of gilts next week and will continue its purchases until 29 July, roughly a week before its next MPC meeting, when it must decide what to do next. It may still then increase its limit; but all the evidence is that it is preparing the markets at least for a marked slowdown in quantitative easing, if not for a complete halt to the policy. We are still a way off the next stage of the Bank beginning to sell gilts back to investors, thus launching quantitative tightening and draining liquidity from the economy.

It now seems that the economy contracted by 0.3-0.4 per cent in the second quarter and could stagnate or creep up slightly in the third, and almost certainly do a bit better in the final quarter. This is hardly a great outcome – in fact, it is quite pathetic – but it is very different from another Great Depression. Figures out yesterday show that the trade deficit is at close to 4-year lows. House prices are now stagnant; and while nobody knows whether they will dip by another 5 per cent or whether the collapse is over, the market has clearly stabilised.

The problem, however, is that we are still being propped up to a huge extent by massive injections of liquidity, ultra-low official short-term interest rates (which only help some, as most must pay much higher rates on their borrowing) and an extreme government borrowing binge.

The weaning process needs to start soon; it will be painful and will guarantee at least two years of paltry growth. The Bank’s gutsiness in starting to wind down its gilts purchases is surprising and very encouraging; but it needs to be much clearer as to what its strategy really is. A speech from the governor setting out the latest thinking would help; failing that, we are in for a choppy few weeks until the minutes are released – and even then we may not really know what to think. No wonder, therefore, that the bond markets were left reeling, with yields surging 0.19 percentage points and prices dipping, as it dawned on traders that without massive support from the Bank, the government will find it hard to shift its debt.

We are at a turning point when it comes to the authorities’ response to the recession. Alistair Darling’s White Paper, while flawed, showed a willingness to reform and strengthen the financial system, not undermine it further; now the Bank too is trying to normalise its policies. But we are still waiting for the biggest shift of them all: a real plan to plug our crazed budget deficit. Don’t hold your breath – until after the general election, that is.

allister.heath@cityam.com